13-2What is real option analysis?Real options exist when managers can influence the size and riskiness of a project’s cash flows by taking different actions during the project’s life.Real option analysis incorporates typical NPV budgeting analysis with an analysis for opportunities resulting from managers’ decisions.

13-4Investment timing optionProject X has an up-front cost of $100,000. The project is expected to produce after-tax cash flows of $33,500 at the end of each of the next four years (t=1, 2, 3, and 4). The project has a WACC=10%. The project’s NPV is $6,190. Therefore, it appears that the company should go ahead with the project.However, if the company waits a year they will find out more about the project’s expected cash flows.

13-5Investment timing optionIf they wait a year:There is a 50% chance the market will be strong and the expected cash flows will be $43,500 a year for four years.There is a 50% chance the market will be weak and the expected cash flows will be $23,500 a year for four years.The project’s initial cost will remain $100,000, but it will be incurred at t=1 only if it makes sense at that time to proceed with the project.

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